All posts tagged Correlations

One complaint among hedge fund managers during the financial crisis was asset correlation: Whatever they did, they couldn’t escape from market exposure. The situation has worsened yet again after a brief period of normality earlier this year, punishing hedge-fund performance.

Correlation between assets spiked to a new high of almost 80% in August, surpassing levels seen during the crisis, says Hennessee Group.

Hedge-fund managers “responded by taking down exposure levels and increasing their cash balance,” Hennessee said in a press release. “Managers also shifted to higher quality, large-cap names and traded out of more economically sensitive names for more recession-resistant ones.” They were then punished when the market roared back at the end of the month.

Gold is down nearly 3% today, at $1823.50, while the S&P 500 is up 2.4%, continuing what has recently been a tight inverse correlation between the two assets. Gold briefly dipped below $1,800 earlier.

There are signs, however, that the inverse link between gold and stocks is growing weaker.

Gold prices have been moving in the opposite direction to equities since the start of August, but this inverse correlation has weakened to negative 0.7 from a peak of negative 0.9, on a scale where negative 1 represents a perfect inverse relationship.

Analysts and strategists have habitually used a pet phrase in the past few weeks to help explain volatile market movements: Equities are moving with currencies. Turns out that’s not really true.

A close look at recent Dow and euro-dollar trading shows there’s no discernible, consistent connection between the pair. The 10-day and 30-day average correlations between the two over the past week max out at 0.23 and 0.49, respectively, according to data from CQG. That’s on a scale where 1.00 means a perfect direct correlation and -1.00 means a perfect indirect correlation.

There doesn’t seem to be a grand explanation for why so many market observers were so wrong. It comes down to the fact that “too many people try to sort of explain away the minutiae of every single move, every single day,” said David Renta, senior vice president for institutional foreign exchange at KeyBank. Sometimes the market just moves without logical explanation.

Diversification has been meaningless for stock investors the past several weeks, points out Bespoke Investment Group today. That could suggest interesting times ahead.

After a four-session-in-five stretch in which all 24 of the S&P 500′s industry groups rose, they fell in each of the past two. That makes six sessions in 10 that the market has seen such lock-step moves. Such a thing has occurred just three other times in the past decade — August 2007, near the market’s peak, November 2008 and June 2010.

Both of those latter cases occurred near intermediate-term lows, notes Bespoke. In light of what happened after all three prior instances, “a stable and sleepy summer of trading is probably out of the question.”

Consumer-discretionary stocks are doing a little less awfully than the rest of the market, hooray, as investors mayhaps realize there’s some good news in the fact that oil prices are being squeezed below $90 a barrel.

The S&P 500 consumer-discretionary sector is down a mere 0.9%, still awful, compared with 1.6% for the broader market and an eye-watering 2.9% for the energy sector. Materials are down 2.3%.

If you think this oil-down, consumer-stocks-up relationship is something that happens all the time, you’re wrong. In fact, commodities and consumer stocks have been highly correlated of late, along with everything else, as part of our wonderful modern algo-driven momentum-heavy risk-on/risk-off market.

The dollar is sharply higher against the euro this morning, while the stock market looks set for some pain at the open.

Yawn, you’re probably saying, tell us something new. The dollar and stocks have been negatively correlated, which in human language means they move in opposite directions, for much of the past two years now. No shock to see the euro down more than 1% against the dollar to less than $1.43 on a morn when Dow and S&P futures are down 106 and 12 points, respectively.

Except, in recent weeks, they haven’t been so much, which is unusual, notes Nomura currency analyst Jens Nordvig.

The S&P 500 is down 5.5% since May 31, he writes, while the dollar is only up 0.5%.

Mr. Nordvig takes a glass-half-full view of this, noting that other risk assets around the world aren’t down as much as the S&P, which suggests the stock market is standing alone and maybe an outlier rather than a signal of rising global risk aversion. That also suggests there’s not a lot more upside to the dollar from here.

But, there’s one gigantic neon caveat here: The picture could change, Mr. Nordvig says, if we get a disorderly Greek default and/or more stress on the global banking system or a sharply lower economy.

This morning, we’re getting bad economic data in the US, lingering worries about the Greek situation and a warning on French banks from Moody’s. Little wonder the dollar and stocks are negatively correlated once again, just like old times.

It was for at least one week, according to Nomura currency strategist Jens Nordvig. In a report this morning, Mr. Nordvig noted that the recent strong tendency of the dollar and the S&P 500 to move in opposite directions was nowhere to be seen last week, even as the S&P 500 dropped for the fifth consecutive week.

He included the accompanying chart, which shows a basket of currencies against the dollar in black and the S&P 500 flipped upside down in orange. During the past week, the dollar fell for the first time with the S&P 500.

Of course, one week does not mean the trend has broken. But the breakdown in correlation (the wonky way of judging the tendency of two assets to move in tandem) has the potential to be a game-changer if it continues.

As we speak, the euro is falling against the dollar, while U.S. stocks are rising. That’s a break from recent history.

The euro and stocks have risen and fallen together more often than not lately, as investors have increasingly taken a binary, as in on or off, approach to risk.

Brown Brothers Harriman currency maven Marc Chandler noted today that the euro and the S&P 500 have moved together about 58% of the time in the past 30 days, up from a low of roughly 0% in January.

For most of the year, the euro benefited from the fact that ECB policy makers are relatively more hawkish than U.S. policy makers, meaning rates are higher in Europe than the U.S. Currency investors tend to favor the higher-yielding curency.

Lately, however, those investors have come back home to the relative safety of the dollar amid global growth worries and fresh eurozone debt fears.

John Higgins of Capital Economics notes the debt fears aren’t going away and suggests the ECB likely won’t be very hawkish for much longer, meaning the euro’s downtrend could continue, whether U.S. stocks are falling or not.

On Jan 11, German and U.S. stocks were heading in opposite directions. The Standard & Poor’s-500 index had gained 1%, while Germany’s DAX had dropped 0.9%.

But a measure of the tendency of two indices to move in sync, known as correlation, was signaling that they wouldn’t go in separate directions for much longer. Normally, the S&P 500 and the DAX move in similar directions—the average 22-day correlation, a measure of short-term moves, between the two markets during the past 10 years is 84%. (A correlation of 100% means two indices move in lockstep all the time; a correlation of -100% means they move in perfect opposition.)

But the 22-day correlation, a measure of short-term moves, had dropped to negative 54% on Jan 11, the weakest since April 1995. And when correlations reach extreme levels relative to history, it’s usually just a matter of time before they reverses direction.

That’s exactly what happened during the past month or so. Since the DAX hit a 2011 low on Jan 10, it has gained 7.7%, while the S&P 500 has gained up 5.8%. Both indices are up 6.8% for the year. And the correlation between the two has also reasserted itself with a vengeance: It’s now 97%, the highest since Sept. 22.

So what’s changed? With the European Union taking steps to backstop its weakest members, investors are finally putting money to work on the continent.

Thomson Reuters

The S&P 500 and Germany’s Dax are back moving together. Top lines are the two indexes, bottom graph shows change in correlation.

As we wrap up this rather short week on the markets, one trend we’d like to highlight is the increasing dispersion we’re seeing between the various sectors of the S&P 500 so far this year. Remember how tightly stocks moved last year?

Between the two European crises and the effects of the Fed’s QE2 program on stocks last year, it seemed everyone was moving up and down together in one tight pack, as markets responded to top-down macro factors — it hardly seemed to matter whether you were a medical device maker or an oil rig operator or a department store.

Well, according to Charles Blood at Brown Brothers Harriman, who dissected this earlier in the week, correlation — or the tendency for the 10 sectors of the stock index to move together — has fallen to nearly a two-year low since the middle of last year. That was after seeing the three-month return correlation peaking at over 90%. (The only other time in recent years that correlation was that high was in the pits of the financial crisis.)

Just three weeks into the year, we’re starting to see signs of that differentiation. The best performer, industrials, is up 3.3%, while the worst, telecoms, down 3.5%. If this de-bunching trend holds up, we can expect to see this gap between winners and losers widen in coming months.

We’re still far from normal. As BBH notes, the long-term average since 1990 is a correlation of about 66%. But this is yet more reason for good stock pickers and money managers to cheer: increasingly, their choices are making a difference. As for bad stock pickers, well, it’s going to get a lot harder to hide.

Check it out. The top panel is the S&P (red) and the DAX (blue). The bottom panel shows the 22-day correlation between the two, which has been collapsing.

As proxies for two big, well-developed global economic powerhouses, it makes sense that German stocks and U.S. equities tend to move in the same direction.

(The measure of that tendency is called correlation. A correlation of 100% means two indices move in lockstep all the time; a correlation of -100% means they move in perfect opposition.)

In fact, the average 22-day correlation — which measures short term mirroring of movements — of the DAX and the S&P indices has been about 62% during the past 20 years.

Here’s the thing; Lately the synchronization of the two markets has collapsed, leaving their correlation at a negative 54%, the weakest since April 1995.

Blame it on peripheral Europe. The big news out of Europe has been renewed fiscal fears in Portugal and Ireland. And for the last month, investors have shown little but disdain for German stocks, despite Germany’s robust economic growth. Germany’s DAX has dropped 1.5%, while the S&P 500, by comparison, has motored ahead with a 3.0% gain, a 4.5% gap.

In the U.S., the focus has been squarely on better-than-expected economic data (Friday’s disappointing payroll number being the exception).

History suggests that eventually the traditional correlated dance between German and U.S. stocks will resume. But how? Will U.S. stocks stumble as euro-worries spread, driving the S&P into the dumps with the DAX? Will Germany stocks shake off jitters about about their fiscally profligate euro-mates? Or will they meet somewhere in the middle?

For much of the fall, after Fed chairman Ben Bernanke announced QE2, stocks rallied as the dollar sank in what felt like tit-for-tat mirror-image fashion, baffling a number of analysts and technicians. (We wrote about it here.)

Well, it’s over, some say.

More than one analyst has landed in our inbox, arguing that the autumnal dance between the U.S. dollar and the stock market has broken down with the wintry chills. As QE2 has receded into the back of investors’ minds, the dollar (DXY, the Dollar Index) and stocks (S&P 500) have begun charting independent paths, with the negative correlation reverting to nearly zero, these analysts say.

The explanation, according to Macro Risk Advisors’ Dean Curnutt: the domestic economic recovery has strengthened, which helps both the dollar and stocks. And even though all signs seem to point to Chairman Bernanke following through on QE2 — further diluting the dollar’s strength — almost all of these expectations had been baked into the dollar’s price since the official $600 billion announcement in early November. “The fact that the SPX is able to ‘power through’ this decoupling seems pretty constructive,” he wrote.

Granted, today isn’t the best example of this: the SPX is down about 0.3% at last glance, while the DXY is up about 0.3%. That looks a lot like what we saw in the fall.

Indeed, no sooner were we ready to shoot off this post than Mark Arbeter, S&P’s technical analyst, crashed into our inbox, arguing that — nope! — the correlation hasn’t broken down at all, and any continued strength in the USD could hamstring the current stock-market rally. Here’s more from Mr. Arbeter:

Over the last year or two, the stock market and the dollar have been linked very closely. Although, sometimes an early reversal to the upside by the dollar will be ignored by stocks, and with it, an outpouring of media attention that the link is no longer valid, it has been our experience that eventually dollar strength equals equity weakness.

So has it or hasn’t it? Far be it from the media to outpour with premature proclamations of this correlation’s death. Suffice it to say, we’ll keep a close eye on things…

Well, it’s not. Bank of America-Merrill Lynch came out with a report yesterday painting the active manager fund community as one big monolithic herd. Well, not exactly, but so far this year only one in five active managers has managed to beat their benchmarks, leaving the others clustered in a tight, tight pack of unspectacular performance.

The point has been made before, but it’s worth going over the reasons driving the trend: investors are fleeing to bonds, for one, and “top-down” macroeconomic factors are pushing stocks — big and small, good and bad — into a closely-packed bundle that rises and falls together. Even with the benefit of hindsight, buying the best 50 stocks and selling the worst 50, Merrill said, would leave you with a 35% return — way below the 50% historical average.

But beleaguered active fund manager, fear not! “Generally periods like today are followed by markets during which stock selection strategies outperform,” the report said, pointing to an October that showed tepid signs of differentiation — thanks in part to clarity on bank regulation, politics, taxes and the Fed.

The latest head-scratching correlation: gold and stocks have been moving in sync since the end of the August. Traditionally, gold and stocks aren’t supposed to go in the same direction. Gold is seen (among other things) as a hedge against inflation, and a catch-all form of protection against all manner of economic woe. Stocks, on the other hand, are supposed to prosper when economic times are good. But in these funny days of QE2, nothing is quite as it seems.

Since Jackson Hole in late August, the S&P 500 and the gold have done a decent job shadowing one another — stocks are up about 14%, gold 12%. The predominant theory is that the dollar is driving the trend. The flood of money-printing devalues the dollar, which sends dollar-denominated commodities higher, while pushing other investors to snap up anything that might resemble a reserve currency. At the same time, the Fed’s help to the economy is supposed to help stocks. Voila.

Not everyone buys that reasoning of course. And it’s not clear whether the stock market will continue to put its faith in the Fed’s healing powers. If doubt creeps in (and it has, to some extent), we could see stocks blink. Oh yes, and there’s that other fresh new wild card too: what if the Fed is forced to back off on its great easing effort?

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